The surging oil prices that are raising exporters' costs to ship everything from steel to sofas to America are encouraging customers to buy more domestically made goods -- and giving the producers of those goods more room to raise their prices.

The result: As Bernanke and fellow policy makers meet in Washington this week, they may find themselves starting to lose the benefit of the flow of inexpensive imports the chairman cited in a June 3 speech as a key force holding down living costs.”

Higher energy costs result in higher shipping costs and that in turn raises the price of all those ‘cheap’ imports from abroad. This results in the substitution effect becoming a prominent factor where consumers start to buy locally. At first glance this would appear to be a positive development as outsourcing to low wage countries becomes less profitable. However, this raises the level of inflation significantly… which means market (interest) rates will also rise significantly.

Over the last twelve months, the Federal Reserve Target Rate went from 5.25% to 2.00% as Ben ‘Helicopter’ Bernanke furiously cut rates. Of the same period mortgage rates on a 15 Year Fixed went from 5.99% to 5.86%. A 30 Year Fixed went from 6.29% to 6.27% and a 1 Year ARM went from 5.54% to 6.15%.

In effect, the Fed has been neutralized by market forces. Now that the Fed rate is at 2.00%, Bernanke doesn’t have any more ammo to cut rates further. Combined with the fact that Bernanke has already swapped out more than 50% of his $800 billion balance sheet and it is now the market that will set rates in spite of what the Fed wants.

The first signs of trouble were evident in January in Fed Cuts, Rates Rise: Bond Vigilantes: “Ben 'Helicopter' Bernanke cut and he cut hard... the Bond Vigilantes came and and raised rates on everything along the curve.

The curve steepened as intended, and this will eventually help the banks. However, if yields continue to rise are simply ignore further cuts, then the strapped consumers won't see the benefits of a lower Fed funds rate. Looks like mortgage rates won't be coming down as intended...”

Then again in February in Fed Cuts Rates, Market Raises Rates: “Listen now and listen carefully: The Fed does NOT set rates. It never has and never will. It simply cannot. The Fed can barely and with great difficulty set and maintain the Fed funds target rate. That’s pretty much it. The market ultimately ends up setting all other rates. Understand that and understand it well, because that is how capitalism works.

Rates are set by the voluntary and mutually beneficial interaction of both borrowers and lenders. They settle on a market clearing rate such that both parties benefit… and the Fed be damned. Today, right now, lenders are maxed out and they have no appetite for more debt. That means they can charge a much higher rate for their money and will to discourage borrowing.”

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comments:

Anonymous
said...

Very interesting post.

"The surging oil prices that are raising exporters' costs to ship everything from steel to sofas to America are encouraging customers to buy more domestically made goods -- and giving the producers of those goods more room to raise their prices."

I don't know if this is necessarily true. I recently read in a magazine that the cost of heavy fuel for transport ships is still low because it is an abundant by-product. Do you know if this is the true?

"On Sunday, Democratic presidential candidate Sen. Barack Obama said that as president he would strengthen government oversight of energy traders. His Republican rival, Sen. John McCain, said he has supported efforts to close the "Enron loophole."

"Proposals have included"... "removing speculators from the market entirely and limiting trade to just producers and consumers."..."We can eliminate a major avenue that traders use to avoid oversight," said Stupak at a press conference Friday.

"It's time for Congress to close the Enron loophole and lower our gas and diesel prices by 50%."

I can't believe that the blogs and the market are paying no attention to the oil speculator legislation. This is *HUGE* legislation with zero opposition. Am I missing something here? Or, is this another case where the market is slow to react?

Disclaimer

The Financial Ninja is a collection of my thoughts and opinions about current economic and market conditions. These are not buy and sell recommendations. Use your head and do your own research. This is a forum to stimulate discussion and debate.

About Me

I started trading during the tech bubble when I was still in high school. My trading has financed my education and I have since completed a BA in Economics and an MBA with a concentration in Finance. I have worked as both a proprietary equity and fixed income derivatives trader.